We talk a lot about investor behavior at Azzad. Unlike the ups and downs of markets, it’s one of the few variables investors can control.
Successful investing is hard, but it doesn’t require genius. Often, success simply means identifying your own psychological weaknesses and changing some behaviors in response.
Azzad’s investment advisors have identified five common mistakes they’ve seen over the years. We hope you can use them to improve how you approach the markets.
Mistake 1: Selective Memory
Few of us want to remember a painful event or experience in the past, particularly one that was of our own doing. In terms of investments, we certainly don’t want to remember stock calls that we missed, and especially not ones that proved to be mistakes that ended in losses.
The more confident we are, the more such memories threaten our self-image. How can we be such good investors if we made those mistakes in the past? Instead of remembering the past accurately, we will remember it selectively so that it suits our needs and preserves our self-image.
“If we see ourselves as skilled traders, we often adjust our memories of the poor investment choices we have made,” says Azzad CEO Bashar Qasem. “People think, ‘Maybe it really wasn’t such a bad decision selling that stock,’ or, “I didn’t lose as much money as I thought.'” Over time, our memory of the event will adjust to fit the image we have of ourselves, but it may not necessarily be accurate. This can lead us to overestimate our investment skills and perhaps take unnecessary risks against the advice of investment professionals.
Mistake 2: Loss Aversion
Many investors will focus obsessively on one investment that’s losing money even if the rest of their portfolio is doing well. This behavior is called loss aversion. It’s been shown that investors are more likely to sell winning stocks in an effort to take profits, but are unwilling to accept defeat in the case of the losers. Some market observers have said that more money has probably been lost by investors holding a stock they no longer wanted until they could “at least come out even” than for any other single reason.
Regret also comes into play with loss aversion, and it may make us unable to distinguish between a bad decision and a bad outcome. “We regret a bad outcome, such as a stretch of weak performance from a stock, even if we chose the investment for all the right reasons,” says Azzad financial advisor Ehab Alalfey. “In this case, regret can lead us to make a bad sell decision, such as selling a solid company when its price is low instead of buying more.”
It also doesn’t help that we tend to feel the pain of a loss more strongly than we do the pleasure of a gain. It’s this unwillingness to accept the pain early that might cause us to “ride losers too long” in the vain hope that they’ll turn around and won’t make us face the consequences of our decisions.
Mistake 3: Sunk Costs
This is the idea that we are unable to ignore the “sunk costs” of a decision, even when those costs are unlikely to be recovered.
One example of this would be if we purchased expensive theater tickets only to learn before attending the performance that the play was terrible. Since we paid for the tickets, we would be far more likely to attend the play than we would if those same tickets had been given to us at no cost. Rational behavior would suggest that regardless of whether or not we purchased the tickets, if we heard the play was terrible we would choose to go or not go based on our interest. Instead, our inability to ignore the sunk costs of poor investments causes us to fail to evaluate a situation such as this on its own merits.
Sunk costs may also prompt us to hold on to a stock even as the company’s underlying business falters rather than cutting our losses. If the dropping stock had been a gift, perhaps we wouldn’t hang on quite so long.
Mistake 4: Framing Effect
The framing effect addresses how a reference point, perhaps an inappropriate benchmark, can affect our decision. Let’s assume, for example, that we decide to buy a television. But just before paying $500 for it, we realize it’s $100 cheaper at a store down the street. In this case, we are quite likely to make that trip down the street and buy the less expensive television. However, if we’re buying a new set of living room furniture and the price tag is $5,000, we are unlikely to go down the street to the store selling it for $4,900. Why? Aren’t we still saving $100?
Unfortunately, we tend to view the discount in relative terms rather than absolute terms. When we were buying the television we were saving 20% by going to the second shop, but when we were buying the living room furniture we were saving only 2%. Depending on perception, it can seem like $100 has a different value depending on the situation.
This type of perception can impact investors as well. If you expected your portfolio to grow by 15% in a given year and it actually grew by 10%, you may feel disappointed unless you remember that a 10% increase is still a great annual gain.
Mistake 5: Following the herd
There are thousands and thousands of stocks out there. Investors can’t know them all. In fact, it’s a major endeavor to really know even a few of them. But people are bombarded with stock ideas from television, magazines, websites, and other places. Inevitably, some decide that the latest idea they’ve heard is a better idea than a stock they already own, and they make a trade.
“In many cases a stock comes to the public’s attention because of its strong previous performance, not because of an improvement in the underlying business,” says Azzad’s Alalfey. “Following a stock tip under the assumption that others have more information is actually just following the herd.”
This is not to say that investors should necessarily hold whatever investments they currently own. Some stocks should be sold, either because the underlying businesses have declined or their stock prices greatly exceed their actual value. But it is clear that many individual (and institutional) investors hurt themselves by making too many buy and sell decisions for fallacious reasons.
We can all be much better investors when we learn to select stocks carefully and for the right reasons, often in consultation with our financial advisors, and then actively block out the noise. Any temporary comfort derived from investing with the crowd or following a market guru can lead to fading performance or inappropriate investments for your particular goals.
This article is for informational purposes only and should not be considered financial planning advice.
